Question

a) Assuming an upward sloping yield curve, explain why the swap rate curve is less than the Eurodollar curve for a given maturity.

(b) State an alternative instrument to a Eurodollar future that can be used to hedge interest rate risk, and also state the two different settlement options for this instrument.

Answer 1

Answer: Part (a)

Eurodollar curve is a yield curve over various maturities of the yield curve. Eurodollar futures, is in effect, a time deposit denominated in US dollars, but held outside the US. Hence, eurodollar futures is just like a USD denominated bond available for various maturities.

On the other hand, a "swap curve" is a curve capturing the implied yield curve, based on difference in yields over various maturities, between the two rates associated with an interest rate swap.

While the Eurodollar curve captures the entire yield on investing in eurodollar futures, the swap curve only captures the difference between two rates that make up the swap. Hence, the swap rate is lower than the eurodollar yield for a given maturity and accordingly the swap rate curve is lower than the Eurodollar curve for a given maturity.

Answer: Part (b)

An alternative instrument to the Eurodollar is a Forward Rate Agreement (FRA), which can be effectively used to hedge interest rate risk.

A forward rate agreement is an OTC agreement to settle the interest rate commitment on a notional amount. This is in effect is like entering into Eurodollar futures and hence the pricing of FRA and Eurodollar futures is closely interlinked.

FRAs are by definition settled in cash. The two different settlement options for FRA are - with and without netting. In case of netting, the payer pays the differential amount. If without netting, the respective parties pay the agreed interest obligation on the pre-decided notional amount.